indexes - All posts tagged indexes

The SPDR S&P 500 ETF (SPY) is up a hair since the election. Pundits have been yakking nonstop about Washington’s fiscal cliff since then. Clearly the two must be related.

Or not. Apple (AAPL) is down about 10% since the election. The stock makes up nearly 4% of the S&P 500 ETF, which is more than twice the size of either General Electric (GE) or Chevron (CVX) in the benchmark. If you’re going to blame anything for the late-year stock-market lull, blame Apple.

Murray Coleman, formerly of this blog, makes all these points and more over at the WSJ. Murray also notes the poster-child for the Apple effect: The PowerShares QQQ (QQQ), with more than 18% Apple, and down 7%. The weighting is about equal to the next three biggest stocks in the index, Microsoft (MSFT), Google (GOOG), and Oracle (ORCL).

If you expect an Apple rebound, then load up. But here’s something to warrant caution: What would the S&P ETF look like if and when the fiscal cliff takes its bite?

If we can infer that the market hasn’t priced in anything but good news when it comes to the fiscal cliff — and yes, we can infer that — then this means things are all the likelier to get ugly if we do end up with bad news.

Okay, stocks can’t actually talk. But if they could, most ex-members of the popular Nasdaq 100 index would be saying good things about their lives after leaving the benchmark.

The one-year return of stocks that get kicked out of the index of the biggest nonfinancial stocks on Nasdaq OMX Group’s (NDAQ) tech-heavy exchange is more than 63%, according to Schaeffer’s Investment Research. How could that be?

Try this: It’s not the act of leaving the index that matters. It’s the fact that getting the boot usually coincides with some awfully depressed investor sentiment. And downbeat investors tend to overlook a good value.

It’s something to think about when it comes to Netflix (NFLX), BlackBerry maker Research In Motion (RIMM) and Green Mountain Coffee Roasters (GMCR). All three of those stocks, and seven others, including Electronic Arts (EA) and First Solar (FSLR), will be removed from the Nasdaq 100 as of Monday. All three have fallen on hard times, such that their market values were lapped by others.

Less well known: A subset of mutual funds is turning to the options market to offer something that investors can’t easily replicate on their own.

There are nearly 200 mutual funds active in the options market, and all else equal, many options users have been able to beat peers, according to research released last week by Goldman Sachs (GS). ”Heavy” options users beat competitors by an average of eight percent, with a standard deviation that was five percent lower, according to the team of seven strategists including John Marshall, Marc Irizarry and Krag Gregory.

Holding a combined $460 billion in assets, the average fund in this group increased assets under management from less than $7 billion in 2010 to $11 billion today. Most of them are selling options, with a heavy bias toward income generation. About two thirds use call-option selling strategies, in which money is made by selling bullish options, often against stocks held by the manager (“overwriting” or “covered calls”). Of those, the great majority (nearly 90%) are selling options on single stocks. A quarter of all the funds in the study sell put options.

My headline is a bit cheeky, but watch tomorrow for the first dissemination of the CBOE Low Volatility Index, brought to you by the makers of the “fear gauge.” This index is actually pretty different from popular products that bear the “low volatility” moniker.

The benchmark is a blend of an S&P 500 (SPY) covered-call option-and-stock strategy plus another of the “tail hedge” variety. In the words of CBOE Holdings’ (CBOE) Chicago Board Options Exchange:

The CBOE LOVOL Index measures the performance of a portfolio that overlays SPX and CBOE Volatility Index (VIX) calls over the S&P 500 Index. Specifically, the index is obtained by holding a portfolio of S&P 500 stocks and simultaneously selling SPX calls and buying one-month VIX 30-delta calls on a monthly basis.

In plain English: This index tracks the S&P 500, plus the returns of a “covered call” strategy of selling bullish options, plus buying “disaster insurance” options on the VIX index.

Yes, it’s pretty complex, but then, investors have been willing to go lengths — probably too far — for the promise of smoother returns. The trend has made a winner of products like the PowerShares S&P Low Volatility Portfolio (SPLV), holding the index’s most stable stocks from the last 12 months. It’s also been kind to the iShares MSCI USA Minimum Volatility Index Fund (USMV) and a gaggle of similarly themed funds.

By the way, you can’t “buy” an index, which is true in this case. But there are ways to buy the two options strategies separately. One is the PowerShares S&P 500 BuyWrite Portfolio (PBP). There’s also a recently launched First Trust CBOE S&P 500 VIX Tail Hedge Fund (VIXH), though barely any investors have bought that fund.

The Nasdaq Composite (ONEQ) this afternoon is just about 10% below its recent peak, which is the unofficial marker of a correction. The recent high was reached on Sept. 14, and it’s been tough sledding ever since.

PowerShares QQQ (QQQ), tracking the Nasdaq 100 index, is already in correction territory, at about 11% below its own September high-water mark. This ETF has been weighed down by the roughly 23% slump in Apple’s (AAPL) stock since mid-September. Apple is nearly 18% of the fund.

Standard & Poor’s is warning of “new and risky” dynamics in the market for high-yield bonds, owing to the entry of easy-to-trade exchange-traded funds.

Here’s how the ratings firm’s managing director of global fixed income research Diane Vazza and Evan M. Gunter, associate director, put it in a note from yesterday:

[T]he ease with which investors can enter and exit ETF investments creates new and risky dynamics in the speculative-grade market with the potential flow of “hot money.” Speculative-grade companies have a higher default risk than investment-grade companies. Therefore, when the credit cycle turns against investors, losses from defaults can quickly outstrip the additional interest payments that high-yield investors receive. Since we are entering the stage of declining credit quality in the current credit cycle, the credit quality of an issuer or a portfolio has become paramount.

With that warning, most of the research is geared toward dissecting the portfolios of the two big junk-bond ETFs, the SPDR Barclays Capital High Yield Bond ETF (JNK) and the iShares iBoxx $ High Yield Corporate Bond Fund (HYG). Point one: The junk-bond ETFs hold a few hundred bonds apiece, versus the 1,500 or so rated by S&P. This magnifies the importance of the bonds held by the ETFs.

JNK comes off as slightly “junkier” than HYG by some measures, but not overly so:

The distribution of bond ratings within these ETFs helps to highlight the differences in total returns. HYG has a higher portion of bonds rated ‘BB-’ and higher (44.4% of its net assets) than either JNK (39.8%) or the overall speculative-grade market (40.3%). When the speculative-grade market is expanding, such as we have seen year to date, higher rated securities tend to lag the performance of the lower rated ones.

In fact, HYG has a slightly bigger chunk of the lowest-rated bonds. Both ETFs have bigger proportion of CCC+ and lower bonds than the overall market:

We estimate that issues rated ‘CCC+’ and lower comprise 7.9% of the overall speculative-grade market. In comparison, HYG holds a slightly greater share (11.0%) of these issues in its portfolio than either JNK (9.8%) or the overall market. The proportion of ‘CCC’ to ‘CC’ rated issues is especially important because these issues typically offer the highest yields. Higher allocations to these credits can fuel returns and outperformance when the speculative-grade market is expanding, but they are also the riskiest credits and the most likely to experience losses once the cycle turns negative.

But the proper question is compared to what? Junk-bond ETFs are like a chainsaw: They clear more brush than the weedwhacker investors previously owned. If you’re not careful with the more powerful tool, you could cut off your hand. It doesn’t mean you should never own a chainsaw.

Correction, Soft, Uncallused Hands Dept., 12:04 p.m.:Jason Zweig of the WSJ points out that the tool of art in the first iteration of this post, a “buzzsaw,” is usually table-mounted, for cutting wood. “Chainsaw” was the mental image. (Growing up in suburban Boston, I didn’t clear a lot of brush.)

South Korea, Israel, Taiwan and the Czech Republic are “countries that bond investors generally classify as EM,” the bank says in a release explaining the moves. All four countries will be considered “emerging” for the purposes of Barclays’ emerging-market bond indices, including those for hard currencies, local currencies and inflation-linked securities, the release said.

It may sound like just another cloistered debate among indexers. But it matters even to ordinary U.S. investors, since so many billions of dollars are now indexed to these benchmarks. Billions in South Korean stock-market exposure will be removed from the Vanguard Emerging Markets (VWO) alone at some point over the next several months.

That’s because the ETF is switching indexes from an MSCI Inc. (MSCI) benchmark that counts Korea an emerging market, to one built by the U.K.’s FTSE Group, which does not. MSCI has cited currency-convertibility issues for keeping Korea in the “emerging” column.

Longtime watchers of the Dow Jones Industrial Average know that the blue-chip index’s methodology gives special influence to high-priced stocks. Right now that means International Business Machines (IBM), Chevron (CVX), Exxon Mobil (XOM) and 3M (MMM).

But lately, the heaviest weights of the Dow’s 30 stocks are moribund. ConvergEx strategist Nicholas Colas ran the numbers for clients this morning, finding that the top seven have contributed just 61 points of the index’s 885-point advance this year. The remaining three are McDonald’s (MCD), Caterpillar (CAT) and United Technologies (UTX). As a group, the stocks — 47% of the index — are “essentially zombies when it comes to influence on the average.”

Enthusiasts of the “Dogs of the Dow” strategy should be taking note now, before year end. (Not to mention holders of the SPDR Dow Jones Industrial Average ETF (DIA).)

So who’s driving the DJIA lately? Home Depot (HD), 164 points, Wal-Mart (WMT), 107 points, Disney (DIS), Travelers (TRV), 100 points, J.P. Morgan Chase (JPM), 58 points, and Bank of America (BAC), 45 points. BAC is especially surprising to see on this list. Its low price of $9 or so limits the effect on the index. Shares are up 70% this year.

To Colas, the takeaway is about consumers and banks. “Pull it all together, and you get the following narrative: U.S. stocks are higher this year because of incremental confidence in the American consumer and domestic banking system,” he writes this morning. “[A]t the end of the day, this market is all about the health of the consumer and the recovery in the financial system.”

About Focus on Funds

As exchange-traded funds and other investing vehicles have ballooned in number, the task of figuring out what works well and what doesn’t has only gotten harder. Barrons.com’s Focus on Funds looks under the hood of ETFs, mutual funds and hedge funds for overlooked values, actionable ideas and the latest pitfalls for fund investors.

Chris Dieterich has covered the U.S. stock market for The Wall Street Journal and Dow Jones Newswires. He is a graduate of Regis University and the Missouri School of Journalism.